Saturday, February 2, 2013

Investing strategies for high promoter pledged highly leveraged companies

The case of Arshiya International excellently covered by Punit Jain of Value Notes (  showcases the perils of investing in innovative companies with great businesses, but which somehow are cash deficient and therefore highly leveraged. Arshiya was a pioneer in logistics parks, was even picked by Kotak as a possible multibagger for 2013, yet was hit by the vicious cycle of panic selling of pledged promoter holding. Other companies like Tulip Telecom, GTL Infrastructure/GTL Limited, Suzlon had faced the same cycle as below
  1. Company has very good growth/business, becomes the darling of Dalal Street with high valuations
  2. In quest to expand, burns cash flow and results in persistently negative free cash flow. However, analyst myopia on just profits ensures that EV/EBITDA type multiples inflate the valuation, without any downward risk adjustment for leverage.
  3. Funding gap(negative FCF means that funding gap should be met through fresh financing) usually through debt, since 'pecking order' theory(tax arbitrage, control issues) and reluctance of promoters to give up stake in growing companies, rules out safer path of equity
  4. Lenders may request promoters to pledge their shares in the company/and or give guarantee. At the high prevailing share prices, a lesser % of pledge may be required.
  5. The bubble bursts through poor market sentiment/poor economic performance. Flight to safety happens with investors going to 'safe' stocks like FMCG/Pharma that actually generate free cash flow. Market Valuations of the leveraged companies dip
  6. The Mark to Market(MTM) valuations of pledged collaterals begin to touch levels exceeding the haircut/margin of safety. Lenders ask for 'top-up' in collateral
  7. Company tries to refinance the loans-approach suppliers/vendors/NBFCs etc in most cases it is just deferring the problem. Sometimes it works(like RCOM got loans from Chinese banks), or else rights issue opted for(like how Dish TV did in 2009)
  8. Promoters try negotiating lower top-up, till then market gets rumours/bear cartel attacks the shares and stock starts hitting lower circuits. Lenders decide to cut their losses and sell the shares at a loss
  9. Promoters sue the lenders for breach of trust/selling the family silver and matter goes to courts. Company lands up in CDR(Corporate Debt restructuring)
  10. CDR compensates the promoters/lenders by issuing shares almost at par! Everyone is happy except the minority shareholders  who do not get chance to rights issue(since preferential allotment done)
Business Today suggests( looking at the re-financing ability of the company-reputed companies and/or asset rich companies may still get secured financing and exit CDR/pledge status. Also, robustness of business model matters in case companies exit. Some pointers before investing for speculative gains in these shares
  1. Evaluate refinancing options-this may stop the cycle at Step 7 instead of going the whole way
  2. Compare with industry parameters, if EV/EBITDA or P/B multiples are dramatically lower, a white knight/takeover offer may arise as happened with Everonn.
  3. Be willing to remain for a long time, but then you may get a Wockhardt!